Monday, April 11, 2005

Buying Stock = Owning Future Earnings

What is the reason for buying a business?
Why would someone pay hard-earned dollars for a share of a company?

When you buy a stock, you lay a claim on the future earnings on that stock. You effectively “own” the future earnings of the company. Let’s consider the broad market index today. The S&P 500 companies are expected to earn $70.20 this year. The S&P 500 index closed at 1181.21 today. If someone buys a share of S&P 500 at $1181.21 today, this person is expected to earn $70.20 dollars in 2005 on the $1181.21 investment.

It is widely known that earnings growth for the S&P 500 in last 70-75 years has been around 5%. If earnings grow by 5% in 2006 from 2005 levels, then this S&P 500 stockholder will earn $73.71 in 2006 from the investment. Let’s continue this further: 2007 earnings should be $77.40, 2008 earnings should be $81.27,…………..

The table below lays out the estimated earnings for the next 20 years. Our S&P 500 stockholder owns these earnings as long as she does not sell her stock.

Calendar YearS&P 500 Expected
Annual Earnings
Estimated Fair
Market Value
2005$70.201053.00
2006$73.211105.65
2007$77.401160.93
2008$81.271218.98
2009$85.331279.93
2010$89.591343.92
2011$94.071411.12
2012$98.781481.68
2013$103.721555.76
2014$108.901633.55
2015$114.351715.23
2016$120.071800.99
2017$126.071891.04
2018$132.371985.59
2019$138.992084.87
2020$145.942189.11
2021$153.242298.57
2022$160.902413.50
2023$168.942534.17
2024$177.392660.88
Total$2321.23-

In the 20th year of her investment (in 2024), she should earn $177.39. As the final total in the above table indicates, her total earnings from her owning this stock for 20 years should be $2321.23.

Let’s suppose at that time, in 2024, our investor decides to sell her stock of S&P 500. Assuming the normal valuations at that time, she should be able to sell her one stock for 15 times the earnings. That is, if S&P 500 stock is expected to earn $177.39 in 2024 then it should sell for $2660.88 ($177.39*15 = $2660.88).

What is the total reward by owning the S&P 500 stock for 20 years?
Total Reward = Total Earnings + (Final Price – Initial Price)
= $2321.23 + ($2660.88 – $1181.21)
= $3800.90

We did not re-invest the earnings in this calculation. If the earnings are re-invested in the stock, then the “Total Reward” should be much higher than $3800.90.

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